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The Year (and More) in International Funds 2007

It was another exciting year in the foreign markets.

Gregg Wolper, 01/29/2008

Everybody loves a winner--or, in investing jargon, an outperformer. International funds have been attracting more and more attention in recent years, and as much as we hope that's because more people are aware of the opportunities they'd previously been passing up, we know pure outperformance plays a big role as well. The MSCI EAFE Index, which covers developed foreign markets, has topped the S&P 500 Index in dollar terms for six consecutive years now.

Regardless of the reasons, reader interest in and media coverage of international funds have increased, and the money has poured in: During 2007, the foreign large-blend category attracted more inflows than any other Morningstar category except the main fixed-income group, intermediate-term bond. So how did international funds do? Now that the year has ended, and a few more weeks have passed--allowing us to see if the year-end trends would have staying power beyond the light-trading, tax-loss-selling holiday season--it's time to review.

More of the Same?
In spite of the acceleration of the subprime-mortgage problem and related credit concerns, in many respects the global markets in the second half of 2007 repeated their trends of the first half. As they did in 2007's first six months, high-flying emerging markets took a dive--sparking concerns that the five-year-long bull run might be over--but then bounced back with a vengeance, soaring even higher than before. Very recently, in late 2007 and especially in early 2008, most emerging markets are falling again, along with the developed markets. Overall, though, emerging markets were the place to be in 2007--with China again the superstar.

On the opposite end of the spectrum was Japan. In that market, a huge rally back in the second half of 2005 had seemed as if it might portend the end of that market's long, long drought. But the market lagged badly in 2006, and in 2007 it slid into losses, and that trend that has continued into 2008. Western European markets, meanwhile, offered a wide variety of returns, but in general they weren't notably better or worse than the U.S. market--with the same sectors, such as energy, holding up well, while others, notably financials that were affected in some way by the U.S. subprime-mortgage chaos, were weak.

Currency moves also made news. As in 2006, however, strong currency gains by the euro and the Canadian and Australian dollars boosted those run-of-the-mill developed-market returns for U.S. fund investors once currency translation was taken into account. (Nearly all U.S.-based international funds are fully or mostly unhedged, which means their returns benefit when foreign currencies rise against the U.S. dollar.) Two differences with 2006, though, were that the British pound's gain against the greenback was minimal rather than substantial, while the yen, which was sluggish in 2006 and the first half of 2007, suddenly gained strength in 2007's second half. That strength has continued into this year, making it one of the few major foreign currencies to maintain its rally in early 2008.

The International Fund Categories
Given these trends in the markets, it's no surprise that the best-performing international categories over the 12 months through Jan. 16, 2008, have been the three that focus exclusively on emerging markets: Pacific/Asia ex-Japan, Latin American stock, and diversified emerging markets. The gains of those groups range from 28% to 34%. It's also no surprise that the worst-performing category is Japan--now showing a painful 17.7% loss for the past 12 months.

Meanwhile, the growth versus value dichotomy that played out in the U.S. market also showed up overseas. Foreign large-growth funds have posted a 5.1% average gain for the 12-month period through Jan. 16, while foreign large-value eked out just a 1.2% return and foreign large-blend landed in between. The same trend played out among smaller stocks, with the foreign small/mid-value category deep in the red with a 6.9% loss, 7 percentage points behind foreign small/mid-growth.

It's worth noting that this review covers only stock funds. If bond funds were included, they'd be one of the better areas: The world-bond category (whose funds invest in the U.S. as well as abroad) is up 10.3% for the period, while the emerging-markets bond group has risen 6.1%.

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